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ISA 315

INTERNATIONAL STANDARD ON AUDITING 315

IDENTIFYING AND ASSESSING THE RISKS OF MATERIAL

MISSTATEMENT THROUGH UNDERSTANDING THE ENTITY AND ITS

ENVIRONMENT

(Effective for audits of financial statements for periods beginning on or after December 15, 2009)

CONTENTS Paragraph

Introduction

Scope of this ISA 1Effective Date 2

Objective 3

Definitions 4

Requirements

Risk Assessment Procedures and Related Activities 5 - 10

The Required Understanding of the Entity and Its Environment,

Including the Entity’s Internal Control

11 - 24

Identifying and Assessing the Risks of Material Misstatement 25 - 31

Documentation 32Application and Other Explanatory Material

Risk Assessment Procedures and Related Activities A1 - A16

The Required Understanding of the Entity and Its Environment,Including the Entity’s Internal Control

A17 - A104

Identifying and Assessing the Risks of Material Misstatement A105 - A130

Documentation A131 - A134

Appendix 1: Internal Control Components

Appendix 2: Conditions and Events That May Indicate Risks of

Material MisstatementInternational Standard on Auditing (ISA) 315, ―Identifying and Assessing the Risks of Material Miss

through Understanding the Entity and Its Environment‖ should be read in conjunction with ISA 200, Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with International

Standards on Auditing.‖

Introduction

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Scope of this ISA

1. This International Standard on Auditing (ISA) deals with the auditor’sresponsibility to identify and assess the risks of material misstatement in the

financial statements, through understanding the entity and its environment,

including the entity’s internal control.

Effective Date

2. This ISA is effective for audits of financial statements for periods beginning on or

after December 15, 2009.

Objective

3. The objective of the auditor is to identify and assess the risks of material

misstatement, whether due to fraud or error, at the financial statement and

assertion levels, through understanding the entity and its environment, includingthe entity’s internal control, thereby providing a basis for designing andimplementing responses to the assessed risks of material misstatement.

Definitions

4. For purposes of the ISAs, the following terms have the meanings attributed below:

1. Assertions – Representations by management, explicit or otherwise, thatare embodied in the financial statements, as used by the auditor to

consider the different types of potential misstatements that may occur.

2.

Business risk – A risk resulting from significant conditions, events,circumstances, actions or inactions that could adversely affect an entity’s

ability to achieve its objectives and execute its strategies, or from thesetting of inappropriate objectives and strategies.

3. Internal control – The process designed, implemented and maintained by

those charged with governance, management and other personnel to provide reasonable assurance about the achievement of an entity’s

objectives with regard to reliability of financial reporting, effectiveness

and efficiency of operations, and compliance with applicable laws and

regulations. The term ―controls‖ refers to any aspects of one or more of the components of internal control.

4. Risk assessment procedures – The audit procedures performed to obtain an

understanding of the entity and its environment, including the entity’s

internal control, to identify and assess the risks of material misstatement,whether due to fraud or error, at the financial statement and assertion

levels.

5. Significant risk – An identified and assessed risk of material misstatementthat, in the auditor’s judgment, requires special audit consideration.

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Requirements

Risk Assessment Procedures and Related Activities

5. The auditor shall perform risk assessment procedures to provide a basis for the

identification and assessment of risks of material misstatement at the financialstatement and assertion levels. Risk assessment procedures by themselves,

however, do not provide sufficient appropriate audit evidence on which to base

the audit opinion. (Ref: Para. A1-A5)6. The risk assessment procedures shall include the following:

1. Inquiries of management, and of others within the entity who in the

auditor’s judgment may have information that is likely to assist inidentifying risks of material misstatement due to fraud or error. (Ref: Para.

A6)

2. Analytical procedures. (Ref: Para. A7-A10)

3. Observation and inspection. (Ref: Para. A11)

7.

The auditor shall consider whether information obtained from the auditor’s clientacceptance or continuance process is relevant to identifying risks of material

misstatement.8. If the engagement partner has performed other engagements for the entity, the

engagement partner shall consider whether information obtained is relevant to

identifying risks of material misstatement.

9. Where the auditor intends to use information obtained from the auditor’s previousexperience with the entity and from audit procedures performed in previous

audits, the auditor shall determine whether changes have occurred since the

previous audit that may affect its relevance to the current audit. (Ref: Para. A12-A13)

10. The engagement partner and other key engagement team members shall discuss

the susceptibility of the entity’s financial statements to material misstatement, and

the application of the applicable financial reporting framework to the entity’sfacts and circumstances. The engagement partner shall determine which matters

are to be communicated to engagement team members not involved in the

discussion. (Ref: Para. A14-A16)

The Required Understanding of the Entity and Its Environment, Including the

Entity’s Internal Control

The Entity and Its Environment

11. The auditor shall obtain an understanding of the following:

1. Relevant industry, regulatory, and other external factors including the

applicable financial reporting framework. (Ref: Para. A17-A22)2. The nature of the entity, including:

1. its operations;

2. its ownership and governance structures;

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3. the types of investments that the entity is making and plans to

make, including investments in special-purpose entities; and

4. the way that the entity is structured and how it is financed, toenable the auditor to understand the classes of transactions,

account balances, and disclosures to be expected in the financial

statements. (Ref: Para. A23-A27)3. The entity’s selection and application of accounting policies, including thereasons for changes thereto. The auditor shall evaluate whether the entity’s

accounting policies are appropriate for its business and consistent with the

applicable financial reporting framework and accounting policies used inthe relevant industry. (Ref: Para. A28)

4. The entity’s objectives and strategies, and those related business risks that

may result in risks of material misstatement. (Ref: Para. A29-A35)

5. The measurement and review of the entity’s financial performance. (Ref:Para. A36-A41)

The Entity’s Internal Control

12. The auditor shall obtain an understanding of internal control relevant to the audit.Although most controls relevant to the audit are likely to relate to financial

reporting, not all controls that relate to financial reporting are relevant to the

audit. It is a matter of the auditor’s professional judgment whether a control,

individually or in combination with others, is relevant to the audit. (Ref: Para.A42-A65)

Nature and Extent of the Understanding of Relevant Controls

13. When obtaining an understanding of controls that are relevant to the audit, theauditor shall evaluate the design of those controls and determine whether theyhave been implemented, by performing procedures in addition to inquiry of the

entity’s personnel. (Ref: Para. A66-A68)

Components of Internal Control

Control environment

14. The auditor shall obtain an understanding of the control environment. As part of obtaining this understanding, the auditor shall evaluate whether:

1. Management, with the oversight of those charged with governance, has

created and maintained a culture of honesty and ethical behavior; and

2. The strengths in the control environment elements collectively provide anappropriate foundation for the other components of internal control, and

whether those other components are not undermined by deficiencies in the

control environment. (Ref: Para. A69-A78)

The entity’s risk assessment process

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15. The auditor shall obtain an understanding of whether the entity has a process for:

1. Identifying business risks relevant to financial reporting objectives;

2. Estimating the significance of the risks;3. Assessing the likelihood of their occurrence; and

4. Deciding about actions to address those risks. (Ref: Para. A79)

16. If the entity has established such a process (referred to hereafter as the ―entity’srisk assessment process‖), the auditor shall obtain an understanding of it, and theresults thereof. If the auditor identifies risks of material misstatement that

management failed to identify, the auditor shall evaluate whether there was an

underlying risk of a kind that the auditor expects would have been identified bythe entity’s risk assessment process. If there is such a risk, the auditor shall obtain

an understanding of why that process failed to identify it, and evaluate whether

the process is appropriate to its circumstances or determine if there is a significant

deficiency in internal control with regard to the entity’s risk assessment process.17. If the entity has not established such a process or has an ad hoc process, the

auditor shall discuss with management whether business risks relevant to financial

reporting objectives have been identified and how they have been addressed. Theauditor shall evaluate whether the absence of a documented risk assessment

process is appropriate in the circumstances, or determine whether it represents a

significant deficiency in internal control. (Ref: Para. A80)

The information system, including the related business processes, relevant to

financial reporting, and communication

18. The auditor shall obtain an understanding of the information system, including the

related business processes, relevant to financial reporting, including the followingareas:

1. The classes of transactions in the entity’s operations that are significant to

the financial statements;

2. The procedures, within both information technology (IT) and manualsystems, by which those transactions are initiated, recorded, processed,

corrected as necessary, transferred to the general ledger and reported in the

financial statements;3. The related accounting records, supporting information and specific

accounts in the financial statements that are used to initiate, record,

process and report transactions; this includes the correction of incorrectinformation and how information is transferred to the general ledger. The

records may be in either manual or electronic form;

4. How the information system captures events and conditions, other than

transactions, that are significant to the financial statements;5. The financial reporting process used to prepare the entity’s financial

statements, including significant accounting estimates and disclosures; and

6. Controls surrounding journal entries, including non-standard journal

entries used to record non-recurring, unusual transactions or adjustments.(Ref: Para. A81-A85)

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19. The auditor shall obtain an understanding of how the entity communicates

financial reporting roles and responsibilities and significant matters relating to

financial reporting, including:1. Communications between management and those charged with

governance; and

2.

External communications, such as those with regulatory authorities. (Ref:Para. A86-A87)

Control activities relevant to the audit

20. The auditor shall obtain an understanding of control activities relevant to the

audit, being those the auditor judges it necessary to understand in order to assessthe risks of material misstatement at the assertion level and design further audit

procedures responsive to assessed risks. An audit does not require an

understanding of all the control activities related to each significant class of

transactions, account balance, and disclosure in the financial statements or to

every assertion relevant to them. (Ref: Para. A88-A94)21. In understanding the entity’s control activities, the auditor shall obtain an

understanding of how the entity has responded to risks arising from IT. (Ref:Para. A95-A97)

Monitoring of controls

22. The auditor shall obtain an understanding of the major activities that the entity

uses to monitor internal control over financial reporting, including those related tothose control activities relevant to the audit, and how the entity initiates remedial

actions to deficiencies in its controls. (Ref: Para. A98-A100)

23. If the entity has an internal audit function, the auditor shall obtain anunderstanding of the following in order to determine whether the internal auditfunction is likely to be relevant to the audit:

1. The nature of the internal audit function’s responsibilities and how the

internal audit function fits in the entity’s organizational structure; and2. The activities performed, or to be performed, by the internal audit

function. (Ref: Para. A101-A103)

24. The auditor shall obtain an understanding of the sources of the information usedin the entity’s monitoring activities, and the basis upon which management

considers the information to be sufficiently reliable for the purpose. (Ref: Para.

A104)

Identifying and Assessing the Risks of Material Misstatement

25. The auditor shall identify and assess the risks of material misstatement at:

1. the financial statement level; and (Ref: Para. A105-A108)

2. the assertion level for classes of transactions, account balances, anddisclosures (Ref: Para. A109-A113), to provide a basis for designing and

performing further audit procedures.

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26. For this purpose, the auditor shall:

1. Identify risks throughout the process of obtaining an understanding of the

entity and its environment, including relevant controls that relate to therisks, and by considering the classes of transactions, account balances, and

disclosures in the financial statements; (Ref: Para. A114-A115)

2.

Assess the identified risks, and evaluate whether they relate more pervasively to the financial statements as a whole and potentially affectmany assertions;

3. Relate the identified risks to what can go wrong at the assertion level,

taking account of relevant controls that the auditor intends to test; and(Ref: Para. A116-A118)

4. Consider the likelihood of misstatement, including the possibility of

multiple misstatements, and whether the potential misstatement is of a

magnitude that could result in a material misstatement.

Risks That Require Special Audit Consideration

27. As part of the risk assessment as described in paragraph 25, the auditor shall

determine whether any of the risks identified are, in the auditor’s judgment, asignificant risk. In exercising this judgment, the auditor shall exclude the effects

of identified controls related to the risk.

28. In exercising judgment as to which risks are significant risks, the auditor shall

consider at least the following:1. Whether the risk is a risk of fraud;

2. Whether the risk is related to recent significant economic, accounting or

other developments and, therefore, requires specific attention;3. The complexity of transactions;

4. Whether the risk involves significant transactions with related parties;

5. The degree of subjectivity in the measurement of financial information

related to the risk, especially those measurements involving a wide rangeof measurement uncertainty; and

6. Whether the risk involves significant transactions that are outside the

normal course of business for the entity, or that otherwise appear to beunusual. (Ref: Para. A119-A123)

29. If the auditor has determined that a significant risk exists, the auditor shall obtain

an understanding of the entity’s controls, including control activities, relevant tothat risk. (Ref: Para. A124-A126)

Risks for Which Substantive Procedures Alone Do Not Provide Sufficient

Appropriate Audit Evidence

30. In respect of some risks, the auditor may judge that it is not possible or practicable

to obtain sufficient appropriate audit evidence only from substantive procedures.Such risks may relate to the inaccurate or incomplete recording of routine and

significant classes of transactions or account balances, the characteristics of which

often permit highly automated processing with little or no manual intervention. In

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such cases, the entity’s controls over such risks are relevant to the audit and the

auditor shall obtain an understanding of them. (Ref: Para. A127-A129)

Revision of Risk Assessment

31. The auditor’s assessment of the risks of material misstatement at the assertionlevel may change during the course of the audit as additional audit evidence is

obtained. In circumstances where the auditor obtains audit evidence from

performing further audit procedures, or if new information is obtained, either of which is inconsistent with the audit evidence on which the auditor originally

based the assessment, the auditor shall revise the assessment and modify the

further planned audit procedures accordingly. (Ref: Para. A130)

Documentation

32. The auditor shall include in the audit documentation:

1.

The discussion among the engagement team where required by paragraph10, and the significant decisions reached;2. Key elements of the understanding obtained regarding each of the aspects

of the entity and its environment specified in paragraph 11 and of each of

the internal control components specified in paragraphs 14-24; the sourcesof information from which the understanding was obtained; and the risk assessment procedures performed;

3. The identified and assessed risks of material misstatement at the financial

statement level and at the assertion level as required by paragraph 25; and4. The risks identified, and related controls about which the auditor has

obtained an understanding, as a result of the requirements in paragraphs

27-30. (Ref: Para. A131-A134)

***

Application and Other Explanatory Material

Risk Assessment Procedures and Related Activities (Ref: Para. 5)

A1. Obtaining an understanding of the entity and its environment, including the entity’sinternal control (referred to hereafter as an ―understanding of the entity‖), is a continuous,

dynamic process of gathering, updating and analyzing information throughout the audit.

The understanding establishes a frame of reference within which the auditor plans theaudit and exercises professional judgment throughout the audit, for example, when:

Assessing risks of material misstatement of the financial statements;

Determining materiality in accordance with ISA 320;

Considering the appropriateness of the selection and application of accounting

policies, and the adequacy of financial statement disclosures;

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Identifying areas where special audit consideration may be necessary, for

example, related party transactions, the appropriateness of management’s use of

the going concern assumption, or considering the business purpose of transactions;

Developing expectations for use when performing analytical procedures;

Responding to the assessed risks of material misstatement, including designingand performing further audit procedures to obtain sufficient appropriate auditevidence; and

Evaluating the sufficiency and appropriateness of audit evidence obtained, such as

the appropriateness of assumptions and of management’s oral and writtenrepresentations.

A2. Information obtained by performing risk assessment procedures and related activitiesmay be used by the auditor as audit evidence to support assessments of the risks of

material misstatement. In addition, the auditor may obtain audit evidence about classes of

transactions, account balances, or disclosures, and related assertions, and about the

operating effectiveness of controls, even though such procedures were not specifically planned as substantive procedures or as tests of controls. The auditor also may choose to

perform substantive procedures or tests of controls concurrently with risk assessment procedures because it is efficient to do so.

A3. The auditor uses professional judgment to determine the extent of the understanding

required. The auditor’s primary consideration is whether the understanding that has beenobtained is sufficient to meet the objective stated in this ISA. The depth of the overall

understanding that is required by the auditor is less than that possessed by management in

managing the entity.

A4. The risks to be assessed include both those due to error and those due to fraud, and both are covered by this ISA. However, the significance of fraud is such that further requirements and guidance are included in ISA 240 in relation to risk assessment

procedures and related activities to obtain information that is used to identify the risks of

material misstatement due to fraud.

A5. Although the auditor is required to perform all the risk assessment procedures

described in paragraph 6 in the course of obtaining the required understanding of theentity (see paragraphs 11-24), the auditor is not required to perform all of them for each

aspect of that understanding. Other procedures may be performed where the information

to be obtained therefrom may be helpful in identifying risks of material misstatement.

Examples of such procedures include:

Reviewing information obtained from external sources such as trade and

economic journals; reports by analysts, banks, or rating agencies; or regulatory or financial publications.

Making inquiries of the entity’s external legal counsel or of valuation experts that

the entity has used.

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Inquiries of Management and Others within the Entity (Ref: Para. 6(a))

A6. Much of the information obtained by the auditor’s inquiries is obtained frommanagement and those responsible for financial reporting. However, the auditor may also

obtain information, or a different perspective in identifying risks of material

misstatement, through inquiries of others within the entity and other employees withdifferent levels of authority. For example:

Inquiries directed towards those charged with governance may help the auditor understand the environment in which the financial statements are prepared.

Inquiries directed toward internal audit personnel may provide information about

internal audit procedures performed during the year relating to the design andeffectiveness of the entity’s internal control and whether management has

satisfactorily responded to findings from those procedures.

Inquiries of employees involved in initiating, processing or recording complex or

unusual transactions may help the auditor to evaluate the appropriateness of the

selection and application of certain accounting policies. Inquiries directed toward in-house legal counsel may provide information about

such matters as litigation, compliance with laws and regulations, knowledge of fraud or suspected fraud affecting the entity, warranties, post-sales obligations,

arrangements (such as joint ventures) with business partners and the meaning of

contract terms.

Inquiries directed towards marketing or sales personnel may provide informationabout changes in the entity’s marketing strategies, sales trends, or contractual

arrangements with its customers.

Analytical Procedures (Ref: Para. 6(b))

A7. Analytical procedures performed as risk assessment procedures may identify aspectsof the entity of which the auditor was unaware and may assist in assessing the risks of

material misstatement in order to provide a basis for designing and implementing

responses to the assessed risks. Analytical procedures performed as risk assessment procedures may include both financial and non-financial information, for example, the

relationship between sales and square footage of selling space or volume of goods sold.

A8. Analytical procedures may help identify the existence of unusual transactions or

events, and amounts, ratios, and trends that might indicate matters that have audit

implications. Unusual or unexpected relationships that are identified may assist the

auditor in identifying risks of material misstatement, especially risks of materialmisstatement due to fraud.

A9. However, when such analytical procedures use data aggregated at a high level (whichmay be the situation with analytical procedures performed as risk assessment

procedures), the results of those analytical procedures only provide a broad initial

indication about whether a material misstatement may exist. Accordingly, in such cases,consideration of other information that has been gathered when identifying the risks of

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material misstatement together with the results of such analytical procedures may assist

the auditor in understanding and evaluating the results of the analytical procedures.

Considerations Specific to Smaller Entities

A10. Some smaller entities may not have interim or monthly financial information thatcan be used for purposes of analytical procedures. In these circumstances, although the

auditor may be able to perform limited analytical procedures for purposes of planning the

audit or obtain some information through inquiry, the auditor may need to plan to perform analytical procedures to identify and assess the risks of material misstatement

when an early draft of the entity’s financial statements is available.

Observation and Inspection (Ref: Para. 6(c))

A11. Observation and inspection may support inquiries of management and others, andmay also provide information about the entity and its environment. Examples of such

audit procedures include observation or inspection of the following:

The entity’s operations.

Documents (such as business plans and strategies), records, and internal control

manuals.

Reports prepared by management (such as quarterly management reports and

interim financial statements) and those charged with governance (such as minutes

of board of directors’ meetings).

The entity’s premises and plant facilities.

Information Obtained in Prior Periods (Ref: Para. 9)

A12. The auditor’s previous experience with the entity and audit procedures performed in

previous audits may provide the auditor with information about such matters as:

Past misstatements and whether they were corrected on a timely basis.

The nature of the entity and its environment, and the entity’s internal control(including deficiencies in internal control).

Significant changes that the entity or its operations may have undergone since the

prior financial period, which may assist the auditor in gaining a sufficientunderstanding of the entity to identify and assess risks of material misstatement.

A13. The auditor is required to determine whether information obtained in prior periodsremains relevant, if the auditor intends to use that information for the purposes of the

current audit. This is because changes in the control environment, for example, may

affect the relevance of information obtained in the prior year. To determine whether changes have occurred that may affect the relevance of such information, the auditor may

make inquiries and perform other appropriate audit procedures, such as walk-throughs of

relevant systems.

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Discussion among the Engagement Team (Ref: Para. 10)

A14. The discussion among the engagement team about the susceptibility of the entity’sfinancial statements to material misstatement:

Provides an opportunity for more experienced engagement team members,including the engagement partner, to share their insights based on their knowledge

of the entity.

Allows the engagement team members to exchange information about the business risks to which the entity is subject and about how and where the financial

statements might be susceptible to material misstatement due to fraud or error.

Assists the engagement team members to gain a better understanding of the potential for material misstatement of the financial statements in the specific areas

assigned to them, and to understand how the results of the audit procedures that

they perform may affect other aspects of the audit including the decisions about

the nature, timing and extent of further audit procedures.

Provides a basis upon which engagement team members communicate and sharenew information obtained throughout the audit that may affect the assessment of

risks of material misstatement or the audit procedures performed to address theserisks.

ISA 240 provides further requirements and guidance in relation to the discussion amongthe engagement team about the risks of fraud.

A15. It is not always necessary or practical for the discussion to include all members in asingle discussion (as, for example, in a multi-location audit), nor is it necessary for all of

the members of the engagement team to be informed of all of the decisions reached in the

discussion. The engagement partner may discuss matters with key members of theengagement team including, if considered appropriate, those with specific skills or knowledge, and those responsible for the audits of components, while delegating

discussion with others, taking account of the extent of communication considered

necessary throughout the engagement team. A communications plan, agreed by theengagement partner, may be useful.


A16. Many small audits are carried out entirely by the engagement partner (who may be a

sole practitioner). In such situations, it is the engagement partner who, having personallyconducted the planning of the audit, would be responsible for considering the

susceptibility of the entity’s financial statements to material misstatement due to fraud or

error.

The Required Understanding of the Entity and Its Environment, Including the

Entity’s Internal Control

The Entity and Its Environment

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Industry, Regulatory and Other External Factors (Ref: Para. 11(a))

Industry Factors

A17. Relevant industry factors include industry conditions such as the competitive

environment, supplier and customer relationships, and technological developments.Examples of matters the auditor may consider include:

The market and competition, including demand, capacity, and price competition.

Cyclical or seasonal activity.

Product technology relating to the entity’s products.

Energy supply and cost.

A18. The industry in which the entity operates may give rise to specific risks of material

misstatement arising from the nature of the business or the degree of regulation. For example, long-term contracts may involve significant estimates of revenues and expenses

that give rise to risks of material misstatement. In such cases, it is important that theengagement team include members with sufficient relevant knowledge and experience.

Regulatory Factors

A19. Relevant regulatory factors include the regulatory environment. The regulatory

environment encompasses, among other matters, the applicable financial reportingframework and the legal and political environment. Examples of matters the auditor may

consider include:

Accounting principles and industry-specific practices.

Regulatory framework for a regulated industry.

Legislation and regulation that significantly affect the entity’s operations,

including direct supervisory activities.

Taxation (corporate and other).

Government policies currently affecting the conduct of the entity’s business, such

as monetary, including foreign exchange controls, fiscal, financial incentives (for example, government aid programs), and tariffs or trade restrictions policies.

Environmental requirements affecting the industry and the entity’s business.

A20. ISA 250 includes some specific requirements related to the legal and regulatory

framework applicable to the entity and the industry or sector in which the entity operates.

Considerations specific to public sector entities

A21. For the audits of public sector entities, law, regulation other authority may affect theentity’s operations. Such elements are essential to consider when obtaining an

understanding of the entity and its environment.

Other External Factors

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A22. Examples of other external factors affecting the entity that the auditor may consider

include the general economic conditions, interest rates and availability of financing, and

inflation or currency revaluation.

Nature of the Entity (Ref: Para. 11(b))

A23. An understanding of the nature of an entity enables the auditor to understand such

matters as:

Whether the entity has a complex structure, for example, with subsidiaries or

other components in multiple locations. Complex structures often introduce issuesthat may give rise to risks of material misstatement. Such issues may include

whether goodwill, joint ventures, investments, or special-purpose entities are

accounted for appropriately.

The ownership, and relations between owners and other people or entities. Thisunderstanding assists in determining whether related party transactions have been

identified and accounted for appropriately. ISA 550 establishes requirements and provides guidance on the auditor’s considerations relevant to related parties.

A24. Examples of matters that the auditor may consider when obtaining an understanding

of the nature of the entity include:

Business operations – such as:

o Nature of revenue sources, products or services, and markets, includinginvolvement in electronic commerce such as Internet sales and marketing

activities.

o Conduct of operations (for example, stages and methods of production, or

activities exposed to environmental risks).o Alliances, joint ventures, and outsourcing activities.

o Geographic dispersion and industry segmentation.

o Location of production facilities, warehouses, and offices, and locationand quantities of inventories.

o Key customers and important suppliers of goods and services,

employment arrangements (including the existence of union contracts, pension and other post employment benefits, stock option or incentive

bonus arrangements, and government regulation related to employment

matters).

o Research and development activities and expenditures.

o Transactions with related parties.

Investments and investment activities – such as:

o Planned or recently executed acquisitions or divestitures.

o Investments and dispositions of securities and loans.

o Capital investment activities.

o Investments in non-consolidated entities, including partnerships, joint

ventures and special-purpose entities.

Financing and financing activities – such as:

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o Major subsidiaries and associated entities, including consolidated and non-

consolidated structures.

o Debt structure and related terms, including off-balance-sheet financingarrangements and leasing arrangements.

o Beneficial owners (local, foreign, business reputation and experience) and

related parties.o Use of derivative financial instruments.

Financial reporting – such as:

o Accounting principles and industry-specific practices, including industry-

specific significant categories (for example, loans and investments for banks, or research and development for pharmaceuticals).

o Revenue recognition practices.

o Accounting for fair values.

o Foreign currency assets, liabilities and transactions.

o Accounting for unusual or complex transactions including those in

controversial or emerging areas (for example, accounting for stock-based

compensation).

A25. Significant changes in the entity from prior periods may give rise to, or change,risks of material misstatement.

Nature of Special Purpose Entities

A26. A special-purpose entity (sometimes referred to as a special purpose vehicle) is an

entity that is generally established for a narrow and well- defined purpose, such as to

effect a lease or a securitization of financial assets, or to carry out research anddevelopment activities. It may take the form of a corporation, trust, partnership or

unincorporated entity. The entity on behalf of which the special-purpose entity has beencreated may often transfer assets to the latter (e.g., as part of a derecognition transactioninvolving financial assets), obtain the right to use the latter’s assets, or perform services

for the latter, while other parties may provide the funding to the latter. As ISA 550

indicates, in some circumstances, a special- purpose entity may be a related party of theentity.

A27. Financial reporting frameworks often specify detailed conditions that are deemed toamount to control, or circumstances under which the special-purpose entity should be

considered for consolidation. The interpretation of the requirements of such frameworks

often demands a detailed knowledge of the relevant agreements involving the special-

purpose entity.

The Entity’s Selection and Application of Accounting Policies (Ref: Para. 11(c))

A28. An understanding of the entity’s selection and application of accounting policies

may encompass such matters as:

The methods the entity uses to account for significant and unusual transactions.

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The effect of significant accounting policies in controversial or emerging areas for

which there is a lack of authoritative guidance or consensus.

Changes in the entity’s accounting policies.

Financial reporting standards and laws and regulations that are new to the entity

and when and how the entity will adopt such requirements.

Objectives and Strategies and Related Business Risks (Ref: Para. 11(d))

A29. The entity conducts its business in the context of industry, regulatory and other internal and external factors. To respond to these factors, the entity’s management or

those charged with governance define objectives, which are the overall plans for the

entity. Strategies are the approaches by which management intends to achieve itsobjectives. The entity’s objectives and strategies may change over time.

A30. Business risk is broader than the risk of material misstatement of the financialstatements, though it includes the latter. Business risk may arise from change or

complexity. A failure to recognize the need for change may also give rise to businessrisk. Business risk may arise, for example, from:

The development of new products or services that may fail;

A market which, even if successfully developed, is inadequate to support a product or service; or

Flaws in a product or service that may result in liabilities and reputational risk.

A31. An understanding of the business risks facing the entity increases the likelihood of

identifying risks of material misstatement, since most business risks will eventually have

financial consequences and, therefore, an effect on the financial statements. However, the

auditor does not have a responsibility to identify or assess all business risks because notall business risks give rise to risks of material misstatement.

A32. Examples of matters that the auditor may consider when obtaining an understanding

of the entity’s objectives, strategies and related business risks that may result in a risk of

material misstatement of the financial statements include:

Industry developments (a potential related business risk might be, for example,

that the entity does not have the personnel or expertise to deal with the changes in

the industry).

New products and services (a potential related business risk might be, for

example, that there is increased product liability).

Expansion of the business (a potential related business risk might be, for example,

that the demand has not been accurately estimated).

New accounting requirements (a potential related business risk might be, for

example, incomplete or improper implementation, or increased costs).

Regulatory requirements (a potential related business risk might be, for example,that there is increased legal exposure).

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Current and prospective financing requirements (a potential related business risk

might be, for example, the loss of financing due to the entity’s inability to meet

requirements).

Use of IT (a potential related business risk might be, for example, that systems

and processes are incompatible).

The effects of implementing a strategy, particularly any effects that will lead tonew accounting requirements (a potential related business risk might be, for example, incomplete or improper implementation).

A33. A business risk may have an immediate consequence for the risk of material

misstatement for classes of transactions, account balances, and disclosures at the

assertion level or the financial statement level. For example, the business risk arising

from a contracting customer base may increase the risk of material misstatementassociated with the valuation of receivables. However, the same risk, particularly in

combination with a contracting economy, may also have a longer-term consequence,

which the auditor considers when assessing the appropriateness of the going concern

assumption. Whether a business risk may result in a risk of material misstatement is,therefore, considered in light of the entity’s circumstances. Examples of conditions and

events that may indicate risks of material misstatement are indicated in Appendix 2.

A34. Usually, management identifies business risks and develops approaches to address

them. Such a risk assessment process is part of internal control and is discussed in

paragraph 15 and paragraphs A79-A80.

Considerations Specific to Public Sector Entities

A35. For the audits of public sector entities, ―management objectives‖ may be influenced

by concerns regarding public accountability and may include objectives which have their source in law, regulation or other authority.

Measurement and Review of the Entity’s Financial Performance (Ref: Para.11(e))

A36. Management and others will measure and review those things they regard as

important. Performance measures, whether external or internal, create pressures on theentity. These pressures, in turn, may motivate management to take action to improve the

business performance or to misstate the financial statements. Accordingly, an

understanding of the entity’s performance measures assists the auditor in considering

whether pressures to achieve performance targets may result in management actions thatincrease the risks of material misstatement, including those due to fraud. See ISA 240 for

requirements and guidance in relation to the risks of fraud.

A37. The measurement and review of financial performance is not the same as the

monitoring of controls (discussed as a component of internal control in paragraphs A98-

A104), though their purposes may overlap:

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The measurement and review of performance is directed at whether business

performance is meeting the objectives set by management (or third parties).

Monitoring of controls is specifically concerned with the effective operation of internal control.

In some cases, however, performance indicators also provide information that enablesmanagement to identify deficiencies in internal control.

A38. Examples of internally-generated information used by management for measuringand reviewing financial performance, and which the auditor may consider, include:

Key performance indicators (financial and non-financial) and key ratios, trends

and operating statistics.

Period-on-period financial performance analyses.

Budgets, forecasts, variance analyses, segment information and divisional,departmental or other level performance reports.

Employee performance measures and incentive compensation policies.

Comparisons of an entity’s performance with that of competitors.

A39. External parties may also measure and review the entity’s financial performance.

For example, external information such as analysts’ reports and credit rating agencyreports may represent useful information for the auditor. Such reports can often beobtained from the entity being audited.

A40. Internal measures may highlight unexpected results or trends requiring management

to determine their cause and take corrective action (including, in some cases, the

detection and correction of misstatements on a timely basis). Performance measures may

also indicate to the auditor that risks of misstatement of related financial statementinformation do exist. For example, performance measures may indicate that the entity has

unusually rapid growth or profitability when compared to that of other entities in the

same industry. Such information, particularly if combined with other factors such as performance-based bonus or incentive remuneration, may indicate the potential risk of

management bias in the preparation of the financial statements.


A41. Smaller entities often do not have processes to measure and review financial performance. Inquiry of management may reveal that it relies on certain key indicators

for evaluating financial performance and taking appropriate action. If such inquiry

indicates an absence of performance measurement or review, there may be an increased

risk of misstatements not being detected and corrected.

The Entity’s Internal Control

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A42. An understanding of internal control assists the auditor in identifying types of

potential misstatements and factors that affect the risks of material misstatement, and in

designing the nature, timing and extent of further audit procedures.

A43. The following application material on internal control is presented in four sections,

as follows:

General Nature and Characteristics of Internal Control.

Controls Relevant to the Audit.

Nature and Extent of the Understanding of Relevant Controls.

Components of Internal Control.

General Nature and Characteristics of Internal Control (Ref: Para. 12)

Purpose of Internal Control

A44. Internal control is designed, implemented and maintained to address identified business risks that threaten the achievement of any of the entity’s objectives that concern:

The reliability of the entity’s financial reporting;

The effectiveness and efficiency of its operations; and

Its compliance with applicable laws and regulations.

The way in which internal control is designed, implemented and maintained varies with

an entity’s size and complexity.

Considerations specific to smaller entities

A45. Smaller entities may use less structured means and simpler processes and procedures to achieve their objectives.

Limitations of Internal Control

A46. Internal control, no matter how effective, can provide an entity with only reasonableassurance about achieving the entity’s financial reporting objectives. The likelihood of

their achievement is affected by the inherent limitations of internal control. These include

the realities that human judgment in decision-making can be faulty and that breakdowns

in internal control can occur because of human error. For example, there may be an error

in the design of, or in the change to, a control. Equally, the operation of a control may not be effective, such as where information produced for the purposes of internal control (for

example, an exception report) is not effectively used because the individual responsiblefor reviewing the information does not understand its purpose or fails to take appropriate

action.

A47. Additionally, controls can be circumvented by the collusion of two or more people

or inappropriate management override of internal control. For example, management may

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enter into side agreements with customers that alter the terms and conditions of the

entity’s standard sales contracts, which may result in improper revenue recognition. Also,

edit checks in a software program that are designed to identify and report transactionsthat exceed specified credit limits may be overridden or disabled.

A48. Further, in designing and implementing controls, management may make judgmentson the nature and extent of the controls it chooses to implement, and the nature and extent

of the risks it chooses to assume.


A49. Smaller entities often have fewer employees which may limit the extent to which

segregation of duties is practicable. However, in a small owner-managed entity, the

owner-manager may be able to exercise more effective oversight than in a larger entity.

This oversight may compensate for the generally more limited opportunities for segregation of duties.

A50. On the other hand, the owner-manager may be more able to override controls because the system of internal control is less structured. This is taken into account by the

auditor when identifying the risks of material misstatement due to fraud.

Division of Internal Control into Components

A51. The division of internal control into the following five components, for purposes of

the ISAs, provides a useful framework for auditors to consider how different aspects of

an entity’s internal control may affect the audit:

1.

The control environment;2. The entity’s risk assessment process;

3. The information system, including the related business processes, relevant tofinancial reporting, and communication;

4. Control activities; and

5. Monitoring of controls.

The division does not necessarily reflect how an entity designs, implements and

maintains internal control, or how it may classify any particular component. Auditorsmay use different terminology or frameworks to describe the various aspects of internal

control, and their effect on the audit than those used in this ISA, provided all the

components described in this ISA are addressed.

A52. Application material relating to the five components of internal control as they

relate to a financial statement audit is set out in paragraphs A69-A104 below. Appendix 1 provides further explanation of these components of internal control.

Characteristics of Manual and Automated Elements of Internal Control Relevant to theAuditor’s Risk Assessment

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A53. An entity’s system of internal control contains manual elements and often contains

automated elements. The characteristics of manual or automated elements are relevant to

the auditor’s risk assessment and further audit procedures based thereon.

A54. The use of manual or automated elements in internal control also affects the manner

in which transactions are initiated, recorded, processed, and reported:

Controls in a manual system may include such procedures as approvals and

reviews of transactions, and reconciliations and follow-up of reconciling items.Alternatively, an entity may use automated procedures to initiate, record, process,

and report transactions, in which case records in electronic format replace paper

documents.

Controls in IT systems consist of a combination of automated controls (for

example, controls embedded in computer programs) and manual controls. Further,

manual controls may be independent of IT, may use information produced by IT,

or may be limited to monitoring the effective functioning of IT and of automated

controls, and to handling exceptions. When IT is used to initiate, record, processor report transactions, or other financial data for inclusion in financial statements,

the systems and programs may include controls related to the correspondingassertions for material accounts or may be critical to the effective functioning of

manual controls that depend on IT.

An entity’s mix of manual and automated elements in internal control varies with the

nature and complexity of the entity’s use of IT.

A55. Generally, IT benefits an entity’s internal control by enabling an entity to:

Consistently apply predefined business rules and perform complex calculations in processing large volumes of transactions or data;

Enhance the timeliness, availability, and accuracy of information;

Facilitate the additional analysis of information;

Enhance the ability to monitor the performance of the entity’s activities and its

policies and procedures;

Reduce the risk that controls will be circumvented; and

Enhance the ability to achieve effective segregation of duties by implementing

security controls in applications, databases, and operating systems.

A56. IT also poses specific risks to an entity’s internal control, including, for example:

Reliance on systems or programs that are inaccurately processing data, processing

inaccurate data, or both.

Unauthorized access to data that may result in destruction of data or improper

changes to data, including the recording of unauthorized or non- existent

transactions, or inaccurate recording of transactions. Particular risks may arisewhere multiple users access a common database.

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The possibility of IT personnel gaining access privileges beyond those necessary

to perform their assigned duties thereby breaking down segregation of duties.

Unauthorized changes to data in master files.

Unauthorized changes to systems or programs.

Failure to make necessary changes to systems or programs.

Inappropriate manual intervention.

Potential loss of data or inability to access data as required.

A57. Manual elements in internal control may be more suitable where judgment anddiscretion are required such as for the following circumstances:

Large, unusual or non-recurring transactions.

Circumstances where errors are difficult to define, anticipate or predict.

In changing circumstances that require a control response outside the scope of an

existing automated control.

In monitoring the effectiveness of automated controls.

A58. Manual elements in internal control may be less reliable than automated elements

because they can be more easily bypassed, ignored, or overridden and they are also more prone to simple errors and mistakes. Consistency of application of a manual control

element cannot therefore be assumed. Manual control elements may be less suitable for

the following circumstances:

High volume or recurring transactions, or in situations where errors that can be

anticipated or predicted can be prevented, or detected and corrected, by control parameters that are automated.

Control activities where the specific ways to perform the control can be

adequately designed and automated.

A59. The extent and nature of the risks to internal control vary depending on the nature

and characteristics of the entity’s information system. The entity responds to the risksarising from the use of IT or from use of manual elements in internal control by

establishing effective controls in light of the characteristics of the entity’s information

system.

Controls Relevant to the Audit

A60. There is a direct relationship between an entity’s objectives and the controls it

implements to provide reasonable assurance about their achievement. The entity’s

objectives, and therefore controls, relate to financial reporting, operations and

compliance; however, not all of these objectives and controls are relevant to the auditor’srisk assessment.

A61. Factors relevant to the auditor’s judgment about whether a control, individually or

in combination with others, is relevant to the audit may include such matters as the

following:

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Materiality.

The significance of the related risk.

The size of the entity.

The nature of the entity’s business, including its organization and ownership

characteristics.

The diversity and complexity of the entity’s operations.

Applicable legal and regulatory requirements.

The circumstances and the applicable component of internal control.

The nature and complexity of the systems that are part of the entity’s internal

control, including the use of service organizations.

Whether, and how, a specific control, individually or in combination with others,

prevents, or detects and corrects, material misstatement.

A62. Controls over the completeness and accuracy of information produced by the entity

may be relevant to the audit if the auditor intends to make use of the information in

designing and performing further procedures. Controls relating to operations and

compliance objectives may also be relevant to an audit if they relate to data the auditor evaluates or uses in applying audit procedures.

A63. Internal control over safeguarding of assets against unauthorized acquisition, use, or

disposition may include controls relating to both financial reporting and operations

objectives. The auditor’s consideration of such controls is generally limited to those

relevant to the reliability of financial reporting.

A64. An entity generally has controls relating to objectives that are not relevant to an

audit and therefore need not be considered. For example, an entity may rely on asophisticated system of automated controls to provide efficient and effective operations

(such as an airline’s system of automated controls to maintain flight schedules), but thesecontrols ordinarily would not be relevant to the audit. Further, although internal controlapplies to the entire entity or to any of its operating units or business processes, an

understanding of internal control relating to each of the entity’s operating units and

business processes may not be relevant to the audit.

Considerations Specific to Public Sector Entities

A65. Public sector auditors often have additional responsibilities with respect to internal

control, for example to report on compliance with an established code of practice. Public

sector auditors can also have responsibilities to report on compliance with law, regulationor other authority. As a result, their review of internal control may be broader and more

detailed.

Nature and Extent of the Understanding of Relevant Controls (Ref: Para. 13)

A66. Evaluating the design of a control involves considering whether the control ,individually or in combination with other controls, is capable of effectively preventing, or

detecting and correcting, material misstatements. Implementation of a control means that

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the control exists and that the entity is using it. There is little point in assessing the

implementation of a control that is not effective, and so the design of a control is

considered first. An improperly designed control may represent a significant deficiency ininternal control.

A67. Risk assessment procedures to obtain audit evidence about the design andimplementation of relevant controls may include:

Inquiring of entity personnel.

Observing the application of specific controls.

Inspecting documents and reports.

Tracing transactions through the information system relevant to financialreporting.

Inquiry alone, however, is not sufficient for such purposes.

A68. Obtaining an understanding of an entity’s controls is not sufficient to test their operating effectiveness, unless there is some automation that provides for the consistentoperation of the controls. For example, obtaining audit evidence about the

implementation of a manual control at a point in time does not provide audit evidence

about the operating effectiveness of the control at other times during the period under audit. However, because of the inherent consistency of IT processing (see paragraphA55), performing audit procedures to determine whether an automated control has been

implemented may serve as a test of that control’s operating effectiveness, depending on

the auditor’s assessment and testing of controls such as those over program changes.Tests of the operating effectiveness of controls are further described in ISA 330.

Components of Internal Control — Control Environment (Ref: Para. 14)

A69. The control environment includes the governance and management functions andthe attitudes, awareness, and actions of those charged with governance and management

concerning the entity’s internal control and its importance in the entity. The control

environment sets the tone of an organization, influencing the control consciousness of its

people.

A70. Elements of the control environment that may be relevant when obtaining an

understanding of the control environment include the following:

1.

Communication and enforcement of integrity and ethical values – These areessential elements that influence the effectiveness of the design, administrationand monitoring of controls.

2. Commitment to competence – Matters such as management’s consideration of the

competence levels for particular jobs and how those levels translate into requisiteskills and knowledge.

3. Participation by those charged with governance – Attributes of those charged

with governance such as:

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o Their independence from management.

o Their experience and stature.

o The extent of their involvement and the information they receive, and thescrutiny of activities.

o The appropriateness of their actions, including the degree to which

difficult questions are raised and pursued with management, and their interaction with internal and external auditors.4. Management’s philosophy and operating style – Characteristics such as

management’s:

o Approach to taking and managing business risks.

o Attitudes and actions toward financial reporting.

o Attitudes toward information processing and accounting functions and

personnel.

5. Organizational structure – The framework within which an entity’s activities for achieving its objectives are planned, executed, controlled, and reviewed.

6. Assignment of authority and responsibility – Matters such as how authority and

responsibility for operating activities are assigned and how reporting relationshipsand authorization hierarchies are established.

7. Human resource policies and practices – Policies and practices that relate to, for

example, recruitment, orientation, training, evaluation, counselling, promotion,

compensation, and remedial actions.

Audit Evidence for Elements of the Control Environment

A71. Relevant audit evidence may be obtained through a combination of inquiries and

other risk assessment procedures such as corroborating inquiries through observation or inspection of documents. For example, through inquiries of management and employees,

the auditor may obtain an understanding of how management communicates to

employees its views on business practices and ethical behavior. The auditor may then

determine whether relevant controls have been implemented by considering, for example,whether management has a written code of conduct and whether it acts in a manner that

supports the code.

Effect of the Control Environment on the Assessment of the Risks of Material

Misstatement

A72. Some elements of an entity’s control environment have a pervasive effect on

assessing the risks of material misstatement. For example, an entity’s control

consciousness is influenced significantly by those charged with governance, because oneof their roles is to counterbalance pressures on management in relation to financial

reporting that may arise from market demands or remuneration schemes. The

effectiveness of the design of the control environment in relation to participation by those

charged with governance is therefore influenced by such matters as:

Their independence from management and their ability to evaluate the actions of management.

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Whether they understand the entity’s business transactions.

The extent to which they evaluate whether the financial statements are prepared in

accordance with the applicable financial reporting framework.

A73. An active and independent board of directors may influence the philosophy and

operating style of senior management. However, other elements may be more limited intheir effect. For example, although human resource policies and practices directed toward

hiring competent financial, accounting, and IT personnel may reduce the risk of errors in

processing financial information, they may not mitigate a strong bias by top managementto overstate earnings.

A74. The existence of a satisfactory control environment can be a positive factor whenthe auditor assesses the risks of material misstatement. However, although it may help

reduce the risk of fraud, a satisfactory control environment is not an absolute deterrent to

fraud. Conversely, deficiencies in the control environment may undermine the

effectiveness of controls, in particular in relation to fraud. For example, management’s

failure to commit sufficient resources to address IT security risks may adversely affectinternal control by allowing improper changes to be made to computer programs or to

data, or unauthorized transactions to be processed. As explained in ISA 330, the controlenvironment also influences the nature, timing and extent of the auditor’s further

procedures.

A75. The control environment in itself does not prevent, or detect and correct, a material

misstatement. It may, however, influence the auditor’s evaluation of the effectiveness of

other controls (for example, the monitoring of controls and the operation of specific

control activities) and thereby, the auditor’s assessment of the risks of materialmisstatement.


A76. The control environment within small entities is likely to differ from larger entities.For example, those charged with governance in small entities may not include an

independent or outside member, and the role of governance may be undertaken directly

by the owner-manager where there are no other owners. The nature of the controlenvironment may also influence the significance of other controls, or their absence. For

example, the active involvement of an owner-manager may mitigate certain of the risks

arising from a lack of segregation of duties in a small entity; it may, however, increase

other risks, for example, the risk of override of controls.

A77. In addition, audit evidence for elements of the control environment in smaller

entities may not be available in documentary form, in particular where communication between management and other personnel may be informal, yet effective. For example,

small entities might not have a written code of conduct but, instead, develop a culture that

emphasizes the importance of integrity and ethical behavior through oral communicationand by management example.

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A78. Consequently, the attitudes, awareness and actions of management or the owner-

manager are of particular importance to the auditor’s understanding of a smaller entity’s

control environment.

Components of Internal Control —The Entity’s Risk Assessment Process (Ref: Para. 15)

A79. The entity’s risk assessment process forms the basis for how management

determines the risks to be managed. If that process is appropriate to the circumstances,

including the nature, size and complexity of the entity, it assists the auditor in identifyingrisks of material misstatement. Whether the entity’s risk assessment pr ocess is

appropriate to the circumstances is a matter of judgment.

Considerations Specific to Smaller Entities (Ref: Para. 17)

A80. There is unlikely to be an established risk assessment process in a small entity. Insuch cases, it is likely that management will identify risks through direct personal

involvement in the business. Irrespective of the circumstances, however, inquiry aboutidentified risks and how they are addressed by management is still necessary.

Components of Internal Control — The Information System, Including Related Business

Processes, Relevant to Financial Reporting, and Communication

The Information System, Including Related Business Processes, Relevant to FinancialReporting (Ref: Para. 18).

A81. The information system relevant to financial reporting objectives, which includes

the accounting system, consists of the procedures and records designed and established

to:

Initiate, record, process, and report entity transactions (as well as events and

conditions) and to maintain accountability for the related assets, liabilities, and

equity;

Resolve incorrect processing of transactions, for example, automated suspensefiles and procedures followed to clear suspense items out on a timely basis;

Process and account for system overrides or bypasses to controls;

Transfer information from transaction processing systems to the general ledger;

Capture information relevant to financial reporting for events and conditions other

than transactions, such as the depreciation and amortization of assets and changes

in the recoverability of accounts receivables; and Ensure information required to be disclosed by the applicable financial reporting

framework is accumulated, recorded, processed, summarized and appropriately

reported in the financial statements.

Journal entries

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A82. An entity’s information system typically includes the use of standard journal entries

that are required on a recurring basis to record transactions. Examples might be journal

entries to record sales, purchases, and cash disbursements in the general ledger, or torecord accounting estimates that are periodically made by management, such as changes

in the estimate of uncollectible accounts receivable.

A83. An entity’s financial reporting process also includes the use of non-standard journal

entries to record non-recurring, unusual transactions or adjustments. Examples of such

entries include consolidating adjustments and entries for a business combination or disposal or non-recurring estimates such as the impairment of an asset. In manual general

ledger systems, non-standard journal entries may be identified through inspection of

ledgers, journals, and supporting documentation. When automated procedures are used to

maintain the general ledger and prepare financial statements, such entries may exist onlyin electronic form and may therefore be more easily identified through the use of

computer-assisted audit techniques.

Related business processes

A84. An entity’s business processes are the activities designed to:

Develop, purchase, produce, sell and distribute an entity’s products and services;

Ensure compliance with laws and regulations; and

Record information, including accounting and financial reporting information.

Business processes result in the transactions that are recorded, processed and reported by

the information system. Obtaining an understanding of the entity’s business processes,

which include how transactions are originated, assists the auditor obtain an understanding

of the entity’s information system relevant to financial reporting in a manner that isappropriate to the entity’s circumstances.


A85. Information systems and related business processes relevant to financial reporting insmall entities are likely to be less sophisticated than in larger entities, but their role is just

as significant. Small entities with active management involvement may not need

extensive descriptions of accounting procedures, sophisticated accounting records, or

written policies. Understanding the entity’s systems and processes may therefore beeasier in an audit of smaller entities, and may be more dependent on inquiry than on

review of documentation. The need to obtain an understanding, however, remains

important.

Communication (Ref: Para. 19)

A86. Communication by the entity of the financial reporting roles and responsibilities

and of significant matters relating to financial reporting involves providing an

understanding of individual roles and responsibilities pertaining to internal control over

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financial reporting. It includes such matters as the extent to which personnel understand

how their activities in the financial reporting information system relate to the work of

others and the means of reporting exceptions to an appropriate higher level within theentity. Communication may take such forms as policy manuals and financial reporting

manuals. Open communication channels help ensure that exceptions are reported and

acted on.


A87. Communication may be less structured and easier to achieve in a small entity than

in a larger entity due to fewer levels of responsibility and management’s greater visibility

and availability.

Components of Internal Control — Control Activities (Ref: Para. 20)

A88. Control activities are the policies and procedures that help ensure that management

directives are carried out. Control activities, whether within IT or manual systems, havevarious objectives and are applied at various organizational and functional levels.Examples of specific control activities include those relating to the following:

Authorization.

Performance reviews.

Information processing.

Physical controls.

Segregation of duties.

A89. Control activities that are relevant to the audit are:

Those that are required to be treated as such, being control activities that relate to

significant risks and those that relate to risks for which substantive proceduresalone do not provide sufficient appropriate audit evidence, as required by

paragraphs 29 and 30, respectively; or

Those that are considered to be relevant in the judgment of the auditor.

A90. The auditor’s judgment about whether a control activity is relevant to the audit is

influenced by the risk that the auditor has identified that may give rise to a materialmisstatement and whether the auditor thinks it is likely to be appropriate to test the

operating effectiveness of the control in determining the extent of substantive testing.

A91. The auditor’s emphasis may be on identifying and obtaining an understanding of

control activities that address the areas where the auditor considers that risks of material

misstatement are likely to be higher. When multiple control activities each achieve thesame objective, it is unnecessary to obtain an understanding of each of the control

activities related to such objective.

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A92. The auditor’s knowledge about the presence or absence of control activities

obtained from the understanding of the other components of internal control assists the

auditor in determining whether it is necessary to devote additional attention to obtainingan understanding of control activities.


A93. The concepts underlying control activities in small entities are likely to be similar to

those in larger entities, but the formality with which they operate may vary. Further,small entities may find that certain types of control activities are not relevant because of

controls applied by management. For example, management’s sole authority for granting

credit to customers and approving significant purchases can provide strong control over important account balances and transactions, lessening or removing the need for more

detailed control activities.

A94. Control activities relevant to the audit of a smaller entity are likely to relate to the

main transaction cycles such as revenues, purchases and employment expenses.

Risks Arising from IT (Ref: Para. 21)

A95. The use of IT affects the way that control activities are implemented. From theauditor ’s perspective, controls over IT systems are effective when they maintain the

integrity of information and the security of the data such systems process, and include

effective general IT controls and application controls.

A96. General IT controls are policies and procedures that relate to many applications and

support the effective functioning of application controls. They apply to mainframe,

miniframe, and end-user environments. General IT controls that maintain the integrity of information and security of data commonly include controls over the following:

Data center and network operations.

System software acquisition, change and maintenance.

Program change.

Access security.

Application system acquisition, development, and maintenance.

They are generally implemented to deal with the risks referred to in paragraph A56

above.

A97. Application controls are manual or automated procedures that typically operate at a

business process level and apply to the processing of transactions by individual

applications. Application controls can be preventive or detective in nature and aredesigned to ensure the integrity of the accounting records. Accordingly, application

controls relate to procedures used to initiate, record, process and report transactions or

other financial data. These controls help ensure that transactions occurred, are authorized,

and are completely and accurately recorded and processed. Examples include edit checks

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of input data, and numerical sequence checks with manual follow-up of exception reports

or correction at the point of data entry.

Components of Internal Control — Monitoring of Controls (Ref: Para. 22)

A98. Monitoring of controls is a process to assess the effectiveness of internal control performance over time. It involves assessing the effectiveness of controls on a timely

basis and taking necessary remedial actions. Management accomplishes monitoring of

controls through ongoing activities, separate evaluations, or a combination of the two.Ongoing monitoring activities are often built into the normal recurring activities of an

entity and include regular management and supervisory activities.

A99. Management’s monitoring activities may include using information from

communications from external parties such as customer complaints and regulator

comments that may indicate problems or highlight areas in need of improvement.


A100. Management’s monitoring of control is often accomplished by management’s or

the owner-manager’s close involvement in operations. This involvement often will

identify significant variances from expectations and inaccuracies in financial data leadingto remedial action to the control.

Internal Audit Functions (Ref: Para. 23)

A101. The entity’s internal audit function is likely to be relevant to the audit if the nature

of the internal audit function’s responsibilities and activities are related to the entity’s

financial reporting, and the auditor expects to use the work of the internal auditors tomodify the nature or timing, or reduce the extent, of audit procedures to be performed. If

the auditor determines that the internal audit function is likely to be relevant to the audit,ISA 610 applies.

A102. The objectives of an internal audit function, and therefore the nature of itsresponsibilities and its status within the organization, vary widely and depend on the size

and structure of the entity and the requirements of management and, where applicable,

those charged with governance. The responsibilities of an internal audit function mayinclude, for example, monitoring of internal control, risk management, and review of

compliance with laws and regulations. On the other hand, the responsibilities of the

internal audit function may be limited to the review of the economy, efficiency andeffectiveness of operations, for example, and accordingly, may not relate to the entity’sfinancial reporting.

A103. If the nature of the internal audit function’s responsibilities are related to the

entity’s financial reporting, the external auditor’s consideration of the activities

performed, or to be performed, by the internal audit function may include review of the

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internal audit function’s audit plan for the period, if any, and discussion of that plan with

the internal auditors.

Sources of Information (Ref: Para. 24)

A104. Much of the information used in monitoring may be produced by the entity’sinformation system. If management assumes that data used for monitoring are accurate

without having a basis for that assumption, errors that may exist in the information could

potentially lead management to incorrect conclusions from its monitoring activities.Accordingly, an understanding of:

the sources of the information related to the entity’s monitoring activities; and

the basis upon which management considers the information to be sufficiently

reliable for the purpose,

is required as part of the auditor’s understanding of the entity’s monitoring activities as a

component of internal control.

Identifying and Assessing the Risks of Material Misstatement

Assessment of Risks of Material Misstatement at the Financial Statement Level (Ref:Para. 25 (a))

A105. Risks of material misstatement at the financial statement level refer to risks that

relate pervasively to the financial statements as a whole and potentially affect many

assertions. Risks of this nature are not necessarily risks identifiable with specific

assertions at the class of transactions, account balance, or disclosure level. Rather, they

represent circumstances that may increase the risks of material misstatement at theassertion level, for example, through management override of internal control. Financial

statement level risks may be especially relevant to the auditor’s consideration of the risksof material misstatement arising from fraud.

A106. Risks at the financial statement level may derive in particular from a deficientcontrol environment (although these risks may also relate to other factors, such as

declining economic conditions). For example, deficiencies such as management’s lack of

competence may have a more pervasive effect on the financial statements and may

require an overall response by the auditor.

A107. The auditor’s understanding of internal control may raise doubts about theauditability of an entity’s financial statements. For example:

Concerns about the integrity of the entity’s management may be so serious as tocause the auditor to conclude that the risk of management misrepresentation in the

financial statements is such that an audit cannot be conducted.

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Concerns about the condition and reliability of an entity’s records may cause the

auditor to conclude that it is unlikely that sufficient appropriate audit evidence

will be available to support an unmodified opinion on the financial statements.

A108. ISA 705 establishes requirements and provides guidance in determining whether

there is a need for the auditor to express a qualified opinion or disclaim an opinion or, asmay be required in some cases, to withdraw from the engagement where withdrawal is

possible under applicable law or regulation.

Assessment of Risks of Material Misstatement at the Assertion Level (Ref: Para. 25(b))

A109. Risks of material misstatement at the assertion level for classes of transactions,

account balances, and disclosures need to be considered because such consideration

directly assists in determining the nature, timing and extent of further audit procedures at

the assertion level necessary to obtain sufficient appropriate audit evidence. In identifyingand assessing risks of material misstatement at the assertion level, the auditor may

conclude that the identified risks relate more pervasively to the financial statements as awhole and potentially affect many assertions.

The Use of Assertions

A110. In representing that the financial statements are in accordance with the applicablefinancial reporting framework, management implicitly or explicitly makes assertionsregarding the recognition, measurement, presentation and disclosure of the various

elements of financial statements and related disclosures.

A111. Assertions used by the auditor to consider the different types of potential

misstatements that may occur fall into the following three categories and may take the

following forms:

1. Assertions about classes of transactions and events for the period under audit:1. Occurrence — transactions and events that have been recorded have

occurred and pertain to the entity.

2. Completeness — all transactions and events that should have been recorded

have been recorded.3. Accuracy — amounts and other data relating to recorded transactions and

events have been recorded appropriately.

4. Cutoff — transactions and events have been recorded in the correct

accounting period.5. Classification — transactions and events have been recorded in the proper

accounts.

2. Assertions about account balances at the period end:1. Existence — assets, liabilities, and equity interests exist.

2. Rights and obligations — the entity holds or controls the rights to assets,

and liabilities are the obligations of the entity.3. Completeness — all assets, liabilities and equity interests that should have

been recorded have been recorded.

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4. Valuation and allocation — assets, liabilities, and equity interests are

included in the financial statements at appropriate amounts and any

resulting valuation or allocation adjustments are appropriately recorded.3. Assertions about presentation and disclosure:

1. Occurrence and rights and obligations — disclosed events, transactions, and

other matters have occurred and pertain to the entity.2. Completeness — all disclosures that should have been included in thefinancial statements have been included.

3. Classification and understandability — financial information is

appropriately presented and described, and disclosures are clearlyexpressed.

4. Accuracy and valuation — financial and other information are disclosed

fairly and at appropriate amounts.

A112. The auditor may use the assertions as described above or may express them

differently provided all aspects described above have been covered. For example, the

auditor may choose to combine the assertions about transactions and events with theassertions about account balances.

Considerations specific to public sector entities

A113. When making assertions about the financial statements of public sector entities, inaddition to those assertions set out in paragraph A111, management may often assert that

transactions and events have been carried out in accordance with law, regulation or other

authority. Such assertions may fall within the scope of the financial statement audit.

Process of Identifying Risks of Material Misstatement (Ref: Para. 26(a))

A114. Information gathered by performing risk assessment procedures, including the

audit evidence obtained in evaluating the design of controls and determining whether

they have been implemented, is used as audit evidence to support the risk assessment.The risk assessment determines the nature, timing and extent of further audit procedures

to be performed.

A115. Appendix 2 provides examples of conditions and events that may indicate the

existence of risks of material misstatement.

Relating Controls to Assertions (Ref: Para. 26(c))

A116. In making risk assessments, the auditor may identify the controls that are likely to prevent, or detect and correct, material misstatement in specific assertions. Generally, it is

useful to obtain an understanding of controls and relate them to assertions in the context

of processes and systems in which they exist because individual control activities oftendo not in themselves address a risk. Often, only multiple control activities, together with

other components of internal control, will be sufficient to address a risk.

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A117. Conversely, some control activities may have a specific effect on an individual

assertion embodied in a particular class of transactions or account balance. For example,

the control activities that an entity established to ensure that its personnel are properlycounting and recording the annual physical inventory relate directly to the existence and

completeness assertions for the inventory account balance.

A118. Controls can be either directly or indirectly related to an assertion. The more

indirect the relationship, the less effective that control may be in preventing, or detecting

and correcting, misstatements in that assertion. For example, a sales manager’s review of a summary of sales activity for specific stores by region ordinarily is only indirectly

related to the completeness assertion for sales revenue. Accordingly, it may be less

effective in reducing risk for that assertion than controls more directly related to that

assertion, such as matching shipping documents with billing documents.

Significant Risks

Identifying Significant Risks (Ref: Para. 28)

A119. Significant risks often relate to significant non-routine transactions or judgmental

matters. Non-routine transactions are transactions that are unusual, due to either size or

nature, and that therefore occur infrequently. Judgmental matters may include thedevelopment of accounting estimates for which there is significant measurementuncertainty. Routine, non-complex transactions that are subject to systematic processing

are less likely to give rise to significant risks.

A120. Risks of material misstatement may be greater for significant non-routine

transactions arising from matters such as the following:

Greater management intervention to specify the accounting treatment.

Greater manual intervention for data collection and processing.

Complex calculations or accounting principles.

The nature of non-routine transactions, which may make it difficult for the entity

to implement effective controls over the risks.

A121. Risks of material misstatement may be greater for significant judgmental matters

that require the development of accounting estimates, arising from matters such as the

following:

Accounting principles for accounting estimates or revenue recognition may besubject to differing interpretation.

Required judgment may be subjective or complex, or require assumptions about

the effects of future events, for example, judgment about fair value.

A122. ISA 330 describes the consequences for further audit procedures of identifying a

risk as significant.

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Significant risks relating to the risks of material misstatement due to fraud

A123. ISA 240 provides further requirements and guidance in relation to theidentification and assessment of the risks of material misstatement due to fraud.

Understanding Controls Related to Significant Risks (Ref: Para. 29)

A124. Although risks relating to significant non-routine or judgmental matters are oftenless likely to be subject to routine controls, management may have other responses

intended to deal with such risks. Accordingly, the auditor’s understanding of whether the

entity has designed and implemented controls for significant risks arising from non-routine or judgmental matters includes whether and how management responds to the

risks. Such responses might include:

Control activities such as a review of assumptions by senior management or experts.

Documented processes for estimations.

Approval by those charged with governance.

A125. For example, where there are one-off events such as the receipt of notice of a

significant lawsuit, consideration of the entity’s response may include such matters aswhether it has been referred to appropriate experts (such as internal or external legal

counsel), whether an assessment has been made of the potential effect, and how it is

proposed that the circumstances are to be disclosed in the financial statements.

A126. In some cases, management may not have appropriately responded to significant

risks of material misstatement by implementing controls over these significant risks.

Failure by management to implement such controls is an indicator of a significant deficiency in internal control. Risks for Which Substantive Procedures Alone Do Not

Provide Sufficient Appropriate Audit Evidence (Ref: Para. 30)

A127. Risks of material misstatement may relate directly to the recording of routine

classes of transactions or account balances, and the preparation of reliable financialstatements. Such risks may include risks of inaccurate or incomplete processing for

routine and significant classes of transactions such as an entity’s revenue, purchases, and

cash receipts or cash payments.

A128. Where such routine business transactions are subject to highly automated

processing with little or no manual intervention, it may not be possible to perform onlysubstantive procedures in relation to the risk. For example, the auditor may consider thisto be the case in circumstances where a significant amount of an entity’s information is

initiated, recorded, processed, or reported only in electronic form such as in an integrated

system. In such cases:

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Audit evidence may be available only in electronic form, and its sufficiency and

appropriateness usually depend on the effectiveness of controls over its accuracy

and completeness.

The potential for improper initiation or alteration of information to occur and not

be detected may be greater if appropriate controls are not operating effectively.

A129. The consequences for further audit procedures of identifying such risks are

described in ISA 330.

Revision of Risk Assessment (Ref: Para. 31)

A130. During the audit, information may come to the auditor’s attention that differs

significantly from the information on which the risk assessment was based. For example,

the risk assessment may be based on an expectation that certain controls are operating

effectively. In performing tests of those controls, the auditor may obtain audit evidencethat they were not operating effectively at relevant times during the audit. Similarly, in

performing substantive procedures the auditor may detect misstatements in amounts or frequency greater than is consistent with the auditor’s risk assessments. In such

circumstances, the risk assessment may not appropriately reflect the true circumstances of the entity and the further planned audit procedures may not be effective in detecting

material misstatements. See ISA 330 for further guidance.

Documentation (Ref: Para. 32)

A131. The manner in which the requirements of paragraph 32 are documented is for the

auditor to determine using professional judgment. For example, in audits of small entities

the documentation may be incorporated in the auditor’s documentation of the overall

strategy and audit plan. Similarly, for example, the results of the risk assessment may bedocumented separately, or may be documented as part of the auditor’s documentation of

further procedures. The form and extent of the documentation is influenced by the nature,

size and complexity of the entity and its internal control, availability of information fromthe entity and the audit methodology and technology used in the course of the audit.

A132. For entities that have uncomplicated businesses and processes relevant to financialreporting, the documentation may be simple in form and relatively brief. It is not

necessary to document the entirety of the auditor’s understanding of the entity and

matters related to it. Key elements of understanding documented by the auditor include

those on which the auditor based the assessment of the risks of material misstatement.

A133. The extent of documentation may also reflect the experience and capabilities of the

members of the audit engagement team. Provided the requirements of ISA 230 are alwaysmet, an audit undertaken by an engagement team comprising less experienced individuals

may require more detailed documentation to assist them to obtain an appropriate

understanding of the entity than one that includes experienced individuals.

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A134. For recurring audits, certain documentation may be carried forward, updated as

necessary to reflect changes in the entity’s business or processes.

Appendix 1

(Ref: 4(c), 14-24, A69-A104)

Internal Control Components

1. This appendix further explains the components of internal control, as set out in

paragraphs 4(c), 14-24 and A69-A104, as they relate to a financial statement

audit.

Control Environment

2. The control environment encompasses the following elements:

1. Communication and enforcement of integrity and ethical values. Theeffectiveness of controls cannot rise above the integrity and ethical values

of the people who create, administer, and monitor them. Integrity and

ethical behavior are the product of the entity’s ethical and behavioralstandards, how they are communicated, and how they are reinforced in

practice. The enforcement of integrity and ethical values includes, for

example, management actions to eliminate or mitigate incentives or

temptations that might prompt personnel to engage in dishonest, illegal, or

unethical acts. The communication of entity policies on integrity andethical values may include the communication of behavioral standards to

personnel through policy statements and codes of conduct and byexample.

2. Commitment to competence. Competence is the knowledge and skills

necessary to accomplish tasks that define the individual’s job.

3. Participation by those charged with governance. An entity’s controlconsciousness is influenced significantly by those charged with

governance. The importance of the responsibilities of those charged with

governance is recognized in codes of practice and other laws and

regulations or guidance produced for the benefit of those charged withgovernance. Other responsibilities of those charged with governance

include oversight of the design and effective operation of whistle blower

procedures and the process for reviewing the effectiveness of the entity’sinternal control.

4. Management’s philosophy and operating style. Management’s philosophy

and operating style encompass a broad range of characteristics. For example, management’s attitudes and actions toward financial reporting

may manifest themselves through conservative or aggressive selection

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from available alternative accounting principles, or conscientiousness and

conservatism with which accounting estimates are developed.

5. Organizational structure. Establishing a relevant organizational structureincludes considering key areas of authority and responsibility and

appropriate lines of reporting. The appropriateness of an entity’s

organizational structure depends, in part, on its size and the nature of itsactivities.6. Assignment of authority and responsibility. The assignment of authority

and responsibility may include policies relating to appropriate business

practices, knowledge and experience of key personnel, and resources provided for carrying out duties. In addition, it may include policies and

communications directed at ensuring that all personnel understand the

entity’s objectives, know how their individual actions interrelate and

contribute to those objectives, and recognize how and for what they will be held accountable.

7. Human resource policies and practices. Human resource policies and

practices often demonstrate important matters in relation to the controlconsciousness of an entity. For example, standards for recruiting the most

qualified individuals – with emphasis on educational background, prior

work experience, past accomplishments, and evidence of integrity and

ethical behavior – demonstrate an entity’s commitment to competent andtrustworthy people. Training policies that communicate prospective roles

and responsibilities and include practices such as training schools and

seminars illustrate expected levels of performance and behavior.Promotions driven by periodic performance appraisals demonstrate the

entity’s commitment to the advancement of qualified personnel to higher

levels of responsibility.

Entity’s Risk Assessment Process

3. For financial reporting purposes, the entity’s risk assessment process includes

how management identifies business risks relevant to the preparation of financial

statements in accordance with the entity’s applicable financial reportingframework, estimates their significance, assesses the likelihood of their

occurrence, and decides upon actions to respond to and manage them and the

results thereof. For example, the entity’s risk assessment process may addresshow the entity considers the possibility of unrecorded transactions or identifies

and analyzes significant estimates recorded in the financial statements.

4. Risks relevant to reliable financial reporting include external and internal events,

transactions or circumstances that may occur and adversely affect an entity’sability to initiate, record, process, and report financial data consistent with the

assertions of management in the financial statements. Management may initiate

plans, programs, or actions to address specific risks or it may decide to accept a

risk because of cost or other considerations. Risks can arise or change due tocircumstances such as the following:

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o Changes in operating environment. Changes in the regulatory or operating

environment can result in changes in competitive pressures and

significantly different risks.

o New personnel. New personnel may have a different focus on or

understanding of internal control.

o New or revamped information systems. Significant and rapid changes ininformation systems can change the risk relating to internal control.

o Rapid growth. Significant and rapid expansion of operations can strain

controls and increase the risk of a breakdown in controls.

o New technology. Incorporating new technologies into production processes or information systems may change the risk associated with

internal control.

o New business models, products, or activities. Entering into business areas

or transactions with which an entity has little experience may introducenew risks associated with internal control.

o Corporate restructurings. Restructurings may be accompanied by staff

reductions and changes in supervision and segregation of duties that maychange the risk associated with internal control.

o Expanded foreign operations. The expansion or acquisition of foreign

operations carries new and often unique risks that may affect internal

control, for example, additional or changed risks from foreign currencytransactions.

o New accounting pronouncements. Adoption of new accounting principles

or changing accounting principles may affect risks in preparing financialstatements.

Information System, Including the Related Business Processes, Relevant to

Financial Reporting, and Communication

5. An information system consists of infrastructure (physical and hardwarecomponents), software, people, procedures, and data. Many information systems

make extensive use of information technology (IT).

6. The information system relevant to financial reporting objectives, which includesthe financial reporting system, encompasses methods and records that:

o Identify and record all valid transactions.

o Describe on a timely basis the transactions in sufficient detail to permit proper classification of transactions for financial reporting.

o Measure the value of transactions in a manner that permits recording their

proper monetary value in the financial statements.

o Determine the time period in which transactions occurred to permitrecording of transactions in the proper accounting period.

o Present properly the transactions and related disclosures in the financial

statements.

7. The quality of system-generated information affects management’s ability tomake appropriate decisions in managing and controlling the entity’s activities and

to prepare reliable financial reports.

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8. Communication, which involves providing an understanding of individual roles

and responsibilities pertaining to internal control over financial reporting, may

take such forms as policy manuals, accounting and financial reporting manuals,and memoranda. Communication also can be made electronically, orally, and

through the actions of management.

Control Activities

9. Generally, control activities that may be relevant to an audit may be categorizedas policies and procedures that pertain to the following:

o Performance reviews. These control activities include reviews and

analyses of actual performance versus budgets, forecasts, and prior period performance; relating different sets of data – operating or financial – to

one another, together with analyses of the relationships and investigative

and corrective actions; comparing internal data with external sources of

information; and review of functional or activity performance.

o Information processing. The two broad groupings of information systemscontrol activities are application controls, which apply to the processing of

individual applications, and general IT controls, which are policies and procedures that relate to many applications and support the effective

functioning of application controls by helping to ensure the continued

proper operation of information systems. Examples of application controls

include checking the arithmetical accuracy of records, maintaining andreviewing accounts and trial balances, automated controls such as edit

checks of input data and numerical sequence checks, and manual follow-

up of exception reports. Examples of general IT controls are programchange controls, controls that restrict access to programs or data, controls

over the implementation of new releases of packaged software

applications, and controls over system software that restrict access to or

monitor the use of system utilities that could change financial data or records without leaving an audit trail.

o Physical controls. Controls that encompass:

The physical security of assets, including adequate safeguards suchas secured facilities over access to assets and records.

The authorization for access to computer programs and data files.

The periodic counting and comparison with amounts shown oncontrol records (for example, comparing the results of cash,

security and inventory counts with accounting records).

The extent to which physical controls intended to prevent theft of assetsare relevant to the reliability of financial statement preparation, and

therefore the audit, depends on circumstances such as when assets are

highly susceptible to misappropriation.

o Segregation of duties. Assigning different people the responsibilities of

authorizing transactions, recording transactions, and maintaining custody

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of assets. Segregation of duties is intended to reduce the opportunities to

allow any person to be in a position to both perpetrate and conceal errors

or fraud in the normal course of the person’s duties. 10. Certain control activities may depend on the existence of appropriate higher level

policies established by management or those charged with governance. For

example, authorization controls may be delegated under established guidelines,such as investment criteria set by those charged with governance; alternatively,non-routine transactions such as major acquisitions or divestments may require

specific high level approval, including in some cases that of shareholders.

Monitoring of Controls

11. An important management responsibility is to establish and maintain internal

control on an ongoing basis. Management’s monitoring of controls includes

considering whether they are operating as intended and that they are modified as

appropriate for changes in conditions. Monitoring of controls may include

activities such as management’s review of whether bank reconciliations are being prepared on a timely basis, internal auditors’ evaluation of sales personnel’s

compliance with the entity’s policies on terms of sales contracts, and a legaldepartment’s oversight of compliance with the entity’s ethical or business practice

policies. Monitoring is done also to ensure that controls continue to operate

effectively over time. For example, if the timeliness and accuracy of bank

reconciliations are not monitored, personnel are likely to stop preparing them.12. Internal auditors or personnel performing similar functions may contribute to the

monitoring of an entity’s controls through separate evaluations. Ordinarily, they

regularly provide information about the functioning of internal control, focusingconsiderable attention on evaluating the effectiveness of internal control, and

communicate information about strengths and deficiencies in internal control and

recommendations for improving internal control.

13. Monitoring activities may include using information from communications fromexternal parties that may indicate problems or highlight areas in need of

improvement. Customers implicitly corroborate billing data by paying their

invoices or complaining about their charges. In addition, regulators maycommunicate with the entity concerning matters that affect the functioning of

internal control, for example, communications concerning examinations by bank

regulatory agencies. Also, management may consider communications relating tointernal control from external auditors in performing monitoring activities.

Appendix 2

(Ref: Para. A33, A115)

Conditions and Events That May Indicate Risks of Material Misstatement

The following are examples of conditions and events that may indicate the existence of

risks of material misstatement. The examples provided cover a broad range of conditions

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and events; however, not all conditions and events are relevant to every audit engagement

and the list of examples is not necessarily complete.

Operations in regions that are economically unstable, for example, countries with

significant currency devaluation or highly inflationary economies.

Operations exposed to volatile markets, for example, futures trading.

Operations that are subject to a high degree of complex regulation.

Going concern and liquidity issues including loss of significant customers.

Constraints on the availability of capital and credit.

Changes in the industry in which the entity operates.

Changes in the supply chain.

Developing or offering new products or services, or moving into new lines of

business.

Expanding into new locations.

Changes in the entity such as large acquisitions or reorganizations or other

unusual events.

Entities or business segments likely to be sold.

The existence of complex alliances and joint ventures.

Use of off balance sheet finance, special-purpose entities, and other complexfinancing arrangements.

Significant transactions with related parties.

Lack of personnel with appropriate accounting and financial reporting skills.

Changes in key personnel including departure of key executives.

Deficiencies in internal control, especially those not addressed by management.

Inconsistencies between the entity’s IT strategy and its business strategies.

Changes in the IT environment.

Installation of significant new IT systems related to financial reporting.

Inquiries into the entity’s operations or financial results by regulatory or

government bodies.

Past misstatements, history of errors or a significant amount of adjustments at

period end.

Significant amount of non-routine or non-systematic transactions including

intercompany transactions and large revenue transactions at period end.

Transactions that are recorded based on management’s intent, for example, debtrefinancing, assets to be sold and classification of marketable securities.

Application of new accounting pronouncements.

Accounting measurements that involve complex processes.

Events or transactions that involve significant measurement uncertainty, includingaccounting estimates.

Pending litigation and contingent liabilities, for example, sales warranties,

financial guarantees and environmental remediation.

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